Time to rethink contractual claims for consequential damages

Most commercial agreements these days contain clauses limiting parties’ liability and subsequently the ability of parties to institute any claims for damages based on contractual breaches.

These limitation clauses generally read as follows:

Neither party shall be liable to the other party for any consequential, indirect, special or incidental damage, whether foreseeable or unforeseeable, regardless of the form or cause of action, whether in contract or delict of for restitution and whether based on this agreement.

Sometimes the only and/or most prominent damages that companies suffer as a result of a breach of contract is a loss of clients and subsequent profit and is it important to legally determine whether loss of profit constitutes direct, indirect, general or special damages as stipulated – and excluded from liability – in the above contract clause.

In Lavery and Co. Ltd v Jungheinrich 1931 AD 156 the court distinguished as follows between general and special damages:

“general damages” as damages that flow naturally and generally from a breach of contract and which the law presumes that the parties thought would result from such a breach of contract; and

“special damages” as damages that, although caused by the breach of the contract are ordinarily regarded in law as being too remote to be recoverable, unless the parties were entering into the contract actually contemplated such damages would likely be caused from a breach of the contract and agreed that the defaulting party will be liable in the event of such breach.

The primary reason for the conclusion of the majority of commercial agreements is to provide services against a fee to gain profit from rendering these services. These types of losses are referred to as “direct” losses and described as “not unlikely“ or foreseeable in Hadley v Baxendale 91854) 9 Ex Ch 341 and Heron ii [1969] 1 AC 350. Courts have recognised that loss of profits arising from a breach of contract can either be a direct loss or an indirect loss, depending on the circumstances, including the nature of the contract and the nature of the breach (Fujitsu v IBM, [2014] EWHC 752 (TCC) and Polypearl Limited v E. on Energy Solutions Limited [2014] EWHC 3045 (QB)).

In Fujitsu v IBM the court had to decide whether an exclusion clause effectively excluded IBM’s liability for all loss of profit (direct and indirect) or for “indirect” loss of profits only. The clause stipulated as follows:

Neither party shall be liable to the other under this sub-contract for loss of profits, revenue, business, goodwill, indirect or consequential loss or damage…

The court ruled that the clause excluded liability of all loss of profit, not just the “indirect” kind and if the parties were of the intention to exclude indirect loss of profit only, they should have made their intentions in this regard clear.

In Polypearl Limited v E. on Energy Solutions Limited the court similarly had to determine whether the following clause excluded liability for all loss of profit or for indirect loss of profit only:

Neither party will be liable to the other for any indirect or consequential loss, (both of which include, without limitation, pure economic loss, loss of profit, loss of business, depletion of goodwill and like loss) howsoever caused (including as a result of negligence) under this agreement, excepts as so far as it relates to personal injury or death caused by negligence.

Polypearl argued that their lost profits on the shortfall were a direct loss and the court agreed. The Court ruled that the clause excluded liability for indirect/consequential loss of profits and not direct loss of profits.

Generally a company’s loss of profit flows naturally from the other party’s breach of contract and that both parties could easily contemplate a loss of such profit upon breach of the contract by either party. Sometimes a party’s breach of contract probably also results from their desire towards greater profit, confirming the profit making goal of the agreement. Under these circumstances a company’s lost profit should accordingly constitute general damage as per the above distinguished terms, as well as a direct loss of profit as per the above case law. The above quoted clause only exclude the recovery of special damages, which leaves general damages open for recovery. On the same basis no damages for loss of profit in respect of potential clients can be claimed, as such damages constitute indirect damages. Courts will generally uphold and give effect to the literal meaning of a clause that has been negotiated between experienced business parties, provided that the clause is clear, unambiguous and not open to more than one meaning and not drafted so widely that a party’s obligations are effectively robbed of contractual force.

In the South African matter of Cirano Investments 307 (Pty) Ltd v Execujet Aviation (Pty) Ltd decided on the Johannesburg High Court on 22 March 2014 the court held in respect of the calculation of contractual damages that:

The fundamental rule in regard to the award of damages for breach of contract is that the suffered should be put in the position he would have occupied had the contract been properly performed, so far as this can be done by payment of money and without undue hardship to the defaulting party. (Victoria Falls & Transvaal Power Co. Ltd v Consolidated Langlaagte Mines Ltd., 1915 AD 1 and Novick v Benjamin 1972 (2) SA 842 (AD).)

Lost profits that represent the benefit-of-the-bargain measure of damages required to restore the plaintiff to the economic position he would have enjoyed if the contract had been performed are “direct” damages when shown to be “conclusively presumed” to have been foreseen by the parties as a usual and necessary consequence of a breach.

If parties honour their contractual agreement with each other, the service rendering party would make considerable profit from the rendering of such services to various clients. These profits are foreseeable by both parties, as is the loss of profit brought about by any breach of contract. It thus seems that this loss of profit constitute direct damages.

In conclusion: in a recent New York Court of Appeals judgement – Biotronik AG v Conor Medsystems Ireland Ltd 2014 WL 1237154 (NY 27 March 2014) – the court held that the lost profit arising from a collateral contract with a third party constituted general (direct) damages and was not exempted by a “consequential damage” exclusion clause. In this case the court also referred to the above discussed matter of Hadley v Baxendale where the general “rule” under English law for the recovery of damages following breach of contract was set down. Recoverable damages are those either (i) arising naturally or directly from the breach of contract, or (ii) within the contemplation of the parties at the time they made the contract. Other losses are irrecoverable as too remote. The English courts have made it repeatedly clear that an exclusion of “indirect or consequential loss” does not exclude “loss of profit” that arises directly and naturally from the breach, that is loss of profits that a reasonable business person would expect to flow from such breach in the usual course of events (Saint Line v Richardsons Westgarth & Co Ltd [1940] 2 KB 49 and British Sugar Projects Limited (1997) 87 BLR 42.).

The agreement in Biotronik v Conor Medsystems contemplated the resale of stents and the contractual price was benchmarked against the resale price. On this basis, the contemplation of collateral relationships was found to be the very essence of the contract. The court held that this meant that lost profits were the “direct and probable result of a breach and thus constituted general damage”. As general damage, the losses could be claimed by Biotronik because they were not excluded by the exemption clause.

Considering that the above is based on English and American law which only have persuasive power in South African courts, the current position in South African law still is that loss of profits, revenue and business are special damages and not general damages and therefore can only be recovered if the test in Lavery and Co. Ltd v Jungheinrich (discussed above) is met. In addition, most contracts have an exclusion for consequential, indirect, special or incidental damage, whether foreseeable or unforeseeable, etc. The language in these exclusion clauses is deliberately tailored to cast its net wide and leads credence to the interpretation that loss of profits is excluded.

But the recent global developments discussed above, beg us to rethink consequential damages and a party’s ability to institute a claim for it.